In May, 2001, the Casualty Actuarial Society (CAS) and the Society of Actuaries (SoA) jointly issued a request for proposals on the research topic “Modeling of Economic Series Coordinated with Interest Rate Scenarios.” The objectives of this request were to develop a research relationship with selected persons to investigate this topic; produce a literature review of work previously done in the area of economic scenario modeling; determine appropriate data sources and methodologies to enhance economic modeling efforts relevant to the actuarial profession; and produce a working model of economic series, coordinated with interest rates, that could be made public and used by actuaries via the CAS/SoA websites to project future economic scenarios. Categories of economic series to be modeled included interest rates, equity price levels, inflation rates, unemployment rates, and real estate price levels. In addition to providing the financial scenario generator model, this project also produced a set of output scenarios for these economic series that could be used directly in financial analysis. This work is summarized in Ahlgrim et al (2006).
The Life Capital Adequacy Subcommittee of the American Academy of Actuaries recommended in a series of reports (October 1999, December 2002, and June 2005) that life insurers implement new tests of capital adequacy which utilize stochastic models for scenario testing of variable products with guarantees. Although the ultimate recommendation is for each insurer to develop its own models, the AAA was encouraged to provide 10,000 pre-packaged scenarios that could be used as an alternative.
As a result of these two projects, practitioners now have a choice between two publicly available financial scenario generators. This paper will serve to explain the underlying processes used in each of the models, compare the output values for common factors, and describe the issues that should be considered when using these models.
The remainder of this paper is organized as follows. Section 2 describes the historical development of actuarial modeling of economic and financial processes, highlighting the growth in popularity of stochastic modeling. Section 3 provides some background on risk-based capital which have progressed in a similar fashion uses of stochastic modeling, namely risk-based capital standards. Section 4 discusses the mathematical and economic details underlying each of the two publicly available financial scenario models. Section 5 analyzes and compares the output and results from each model. Section 6 illustrates the impact these differences using two separate actuarial applications. Section 7 concludes.
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